Redistribution and Output Effects of Inflation

Redistribution Effect of Inflation If we hold Real Output [Real GDP] constant, and at full-employment [NRU], we can assess the effect of inflation on the distribution of income.

Redistribution Effect of Inflation Real and Nominal Income Nominal income … is the number of dollars earned as rent, wages, interest or profit Real income… measures the amount of goods and services nominal income can buy. √ If nominal income rises faster than price level, real income will rise. √ If the price level increases faster than nominal income, then real income will fall. √ Your real income falls only when nominal income fails to keep up with inflation.

workers in declining industries, or without strong unions Unanticipated Inflation Loss √ Inflation “taxes” those who receive relatively fixed incomes: elderly and those on fixed pay scales welfare recipients workers in declining industries, or without strong unions √ Inflation takes away purchasing power. Benefit Inflation “subsidizes” some people who have flexible incomes. workers in expanding industries and union members.

Unanticipated Inflation Loss √ Savers are hurt by inflation. • As prices rise, the real value or purchasing power declines. • Savers are investing funds and hope to earn interest. … If the rate of interest on an investment is less than the rate of inflation, the value of the savings will decline. • Savings accounts, insurance policies, annuities, and other fixed value paper assets are hurt by inflation.

Unanticipated Inflation Loss Unanticipated Inflation Creditors are losers in inflation since they are “stuck” with dollars that have lower purchasing power than the money they lent. Debtors are winners in inflation at the expense of creditors. The borrower receives “dear” money at the time the loan is initiated and repays the loan with “cheap” dollars. Benefit

Unanticipated Inflation Those who benefit Those who lose Flexible Income Fixed Income Spenders?? Savers Debtors Creditors

Anticipated Inflation √ Inflation is less severe if … anticipate inflation … adjust income to reflect the price level changes. √ Cost of living adjustments (COLA’s) clauses in labor contracts give automatic wage increases when inflation occurs. √ Lenders can charge higher interest on loans if they have high expectations for inflation over the life of the loan. This extra interest is called inflation premium.

Anticipated Inflation Inflation Premium—the expected rate of inflation 6% 11% + = Interest Premium 5% Nominal Interest Rate Real Interest Rate

Redistribution Effect of Inflation Deflation…effects described above are now reversed. Fixed income earners, creditors, and savers will all be better off. Mixed Results … we gain and we lose since we all wear many hats —income earner, saver, creditor, debtor, etc. Arbitrariness… effects of inflation occur regardless of society’s goals and values.

Output Effects of Inflation Cost-Push Inflation and Unemployment √ If cost-push inflation occurs in a full employment, the existing level of total spending will buy less real output because of the higher price level. √ Real output would fall and unemployment will rise. √ The cost-push inflation of the 1970’s was caused of the oil shocks throughout the decade.

Stimulus of Demand-Pull Inflation Output Effects of Inflation Qf Quantity Range 2 Range 3 P r i c e l v Range 1 Increases in total spending Stimulus of Demand-Pull Inflation In range 2 there is a tradeoff between output and employment and inflation. Some moderate amount of inflation must be accepted if we are to realize high levels of output and employment.

Output Effects of Inflation Hyperinflation and Breakdown √ Hyperinflation is extremely rapid inflation that can devastate domestic output levels and employment √ Anticipation of future inflation catches hold of the thinking of consumers and firms who make buying and selling decisions in expectation of the coming inflation.

Output Effects of Inflation √ Labor will demand higher wages, and businesses not wanting to risk their prosperity will give in. But…they must raise prices to cover the new cost and the wage-price spiral whirls out of control. Creeping inflation becomes a runaway gallop. √ Economic collapse results often since speculation is rampant. Hoarding and concentration of wealth in “real assets” like gold, jewels, and other metals replaces investment in new capital for businesses.